Illiquid Till Exit: Is the golden era of secondary share sales over for startups?

Any startup that’s raised capital with a valuation in the hundreds of millions is on the radar of hedge funds, secondary market players and various other boiler rooms for private company stocks. (Call them “spawn of Advanced Equities.”) And it’s creating a thorny issue for startup CEOs.

With startups waiting longer than ever to go public (and thus, leaving less hyper-growth on the table for public market investors), public market investors are under pressure to find high-growth opportunities in the private markets. When Dropbox raises $350 million, or Uber raises $1.2 billion, it’s basically like an IPO, except it’s not open to all retail investors.

So these funds are getting aggressive in their quest for private company shares. One way they’re doing that is by blasting out solicitation emails to startup employees, offering to buy their shares at astronomical valuations. The offers might not be serious — it’s hard to know — but its enough for employees to get dollar signs in their eyes. It’s enough to prompt them to ask management about cashing out.

This poses a problem: The company ’s board has a fiduciary duty to take any offers seriously, but at a ridiculous valuation, how can it? Further, if the company does say yes, it now has a random fund in its cap table, at a valuation much higher than the rest of the shares. There’s little precedent for deciding what class of shares the new buyer gets, and at a higher valuation, how many they get. “It’s a CFO’s nightmare,” one VC said. Not to mention, the insider trading laws for public companies apply to private companies as well, making compliance expensive and cumbersome as the shareholder base expands.

Those issues are why, increasingly, companies are following the lead of startups like Dropbox and Uber and saying no to employee share sales. Based on an informal survey of investors, that’s been the trend since Facebook, which turned into the Wild Wild West of secondary shares before its IPO. At the time, SecondMarket and its peers were hailed as an innovative, entrepreneur and employee-friendly way to do business. It creates a real market with real values for private company stock, with less volatility, declared the New York Times. Secondary markets “act as a stent, relieving the congestion in the arteries of capital formation,” proponents told Businessweek in 2011. But the accounting nightmares it created left investors and CEOs who witnessed it turned off by the idea.

The pendulum has since swung in the other direction, the investors Fortune surveyed said. (They requested anonymity to avoid the appearing unfriendly to entrepreneurs.) Venture firms now make strong recommendations to their portfolio company CEOs as early as a Series A fundraising that employee stock sales remain forbidden until a liquidation event. Companies have always had the right to refuse a potential share sale — they’re simply refusing a lot more now. If employees want to cash out, they have to wait for an honest-to-goodness exit.

There’s one little issue with this shift: Saying no to employee requests for share sales becomes a poaching issue. Top executives at companies like Uber and Dropbox are among the most in-demand talent in Silicon Valley, and that’s not lost on Google, Facebook and Apple. The big public companies can offer an executive, say, a $5 million stock package with full liquidity. Uber can offer the promise of an IPO… someday.

The move to more conservative secondary sale policies hasn’t stopped funds and advisory firms focused on buying shares from startup employees. (Take Battery East Group, a firm founded by former BlackRock exec Michael Sobel, and former Maveron advisor Barrett Cohn, for example.) But the new twist on secondaries seems to be loans over share sales. Earlier this month, 137 Ventures raised $137 million to lend money to private company shareholders and employees who are rich on paper with illiquid shares. Another firm called VSL Partners, founded by GSV Capital partner Dave Crowder will offer the same thing.)

So, if startups are becoming stricter about employee share sales, where will the funds hungry for private company shares invest their capital? Turns out, it’s all about who you know. CEOs are much more likely to approve a secondary sale if it’s to a firm they know and trust, and many of the firms springing up to facilitate sales start out with a relationship. Growth-hungry hedge funds and boiler rooms take note — befriend the next Drew Houston or Travis Kalanick, and you might have yourself a deal.

Any startup that’s raised capital with a valuation in the hundreds of millions is on the radar of hedge funds, secondary market players and various other boiler rooms for private company stocks. (Call them “spawn of Advanced Equities.”) And it’s creating a thorny issue for startup CEOs.

With startups waiting longer than ever to go public (and thus, leaving less hyper-growth on the table for public market investors), public market investors are under pressure to find high-growth opportunities in the private markets. When Dropbox raises $350 million, or Uber raises $1.2 billion, it’s basically like an IPO, except it’s not open to all retail investors.

So these funds are getting aggressive in their quest for private company shares. One way they’re doing that is by blasting out solicitation emails to startup employees, offering to buy their shares at astronomical valuations. The offers might not be serious — it’s hard to know — but its enough for employees to get dollar signs in their eyes. It’s enough to prompt them to ask management about cashing out.

This poses a problem: The company ’s board has a fiduciary duty to take any offers seriously, but at a ridiculous valuation, how can it? Further, if the company does say yes, it now has a random fund in its cap table, at a valuation much higher than the rest of the shares. There’s little precedent for deciding what class of shares the new buyer gets, and at a higher valuation, how many they get. “It’s a CFO’s nightmare,” one VC said. Not to mention, the insider trading laws for public companies apply to private companies as well, making compliance expensive and cumbersome as the shareholder base expands.

Those issues are why, increasingly, companies are following the lead of startups like Dropbox and Uber and saying no to employee share sales. Based on an informal survey of investors, that’s been the trend since Facebook, which turned into the Wild Wild West of secondary shares before its IPO. At the time, SecondMarket and its peers were hailed as an innovative, entrepreneur and employee-friendly way to do business. It creates a real market with real values for private company stock, with less volatility, declared the New York Times. Secondary markets “act as a stent, relieving the congestion in the arteries of capital formation,” proponents told Businessweek in 2011. But the accounting nightmares it created left investors and CEOs who witnessed it turned off by the idea.

The pendulum has since swung in the other direction, the investors Fortune surveyed said. (They requested anonymity to avoid the appearing unfriendly to entrepreneurs.) Venture firms now make strong recommendations to their portfolio company CEOs as early as a Series A fundraising that employee stock sales remain forbidden until a liquidation event. Companies have always had the right to refuse a potential share sale — they’re simply refusing a lot more now. If employees want to cash out, they have to wait for an honest-to-goodness exit.

There’s one little issue with this shift: Saying no to employee requests for share sales becomes a poaching issue. Top executives at companies like Uber and Dropbox are among the most in-demand talent in Silicon Valley, and that’s not lost on Google, Facebook and Apple. The big public companies can offer an executive, say, a $5 million stock package with full liquidity. Uber can offer the promise of an IPO… someday.

The move to more conservative secondary sale policies hasn’t stopped funds and advisory firms focused on buying shares from startup employees. (Take Battery East Group, a firm founded by former BlackRock exec Michael Sobel, and former Maveron advisor Barrett Cohn, for example.) But the new twist on secondaries seems to be loans over share sales. Earlier this month, 137 Ventures raised $137 million to lend money to private company shareholders and employees who are rich on paper with illiquid shares. Another firm called VSL Partners, founded by GSV Capital partner Dave Crowder will offer the same thing.)

So, if startups are becoming stricter about employee share sales, where will the funds hungry for private company shares invest their capital? Turns out, it’s all about who you know. CEOs are much more likely to approve a secondary sale if it’s to a firm they know and trust, and many of the firms springing up to facilitate sales start out with a relationship. Growth-hungry hedge funds and boiler rooms take note — befriend the next Drew Houston or Travis Kalanick, and you might have yourself a deal.